Part 5: The financial reporting environment and some current financial reporting issues

Local government: Results of the 2009/10 audits.

5.1
In this Part, we:

  • comment on the financial reporting environment in New Zealand, including work the Ministry of Economic Development (the Ministry) and the Accounting Standards Review Board (ASRB) are doing to shape the future financial reporting environment; and
  • outline current financial reporting issues that affect some entities in local government.

Summary

5.2
Financial reporting is at a crossroads, as a result of discussion documents issued by the Ministry and ASRB in 2009. We are pleased that the discussion documents have led to debate about possible changes to setting financial reporting standards, particularly for the public sector. There appears to be consensus that financial reporting standards need to better deal with the range of entities that report externally.

5.3
Financial reports have generally become more complex and large as a result of the adoption of New Zealand International Financial Reporting Standards (NZ IFRS). We would like to see financial reports simplified. However, we would also like to see some of the stringent requirements in standards, such as those related to hedge accounting for derivative transactions, simplified. In our view, there should be greater room for judgement about when to apply hedge accounting.

5.4
A number of entities, in response to the greater complexity of financial statements and a concern that performance is not being appropriately reported, have started disclosing underlying profits in annual reports. We have concerns about these disclosures because there is no guidance for them.

5.5
On a more positive note, we are pleased with improvements in local authorities' reports on service performance.

The financial reporting environment in New Zealand

5.6
In June 2009, we published a discussion paper entitled The Auditor-General's views on setting financial reporting standards for the public sector. In that paper, we expressed concerns about the ongoing suitability of NZ IFRS for many entities in the public sector. Our hope was that the discussion paper would promote constructive debate about changes needed to setting financial reporting standards, particularly for the public sector.

5.7
Since that report was published, the debate that we sought has been occurring. We note in particular:

  • In September 2009, both the Ministry and the ASRB released for comment discussion documents about the statutory framework for financial reporting.6
  • The Finance and Expenditure Committee has acknowledged the importance of financial reporting in the public sector, and has had the Ministry, the ASRB, the Treasury, and us appear on different occasions to discuss the financial reporting framework and financial reporting standards.
  • There have been a number of conferences and seminars about the future of financial reporting in New Zealand, at which both the Ministry and the ASRB have been prominent.

5.8
We are pleased that the debate looks to have led to consensus that change is needed to setting financial reporting standards in New Zealand. There appears to be consensus that one body should be responsible for all aspects of setting financial reporting standards, and that the financial reporting standards need to change to better deal with the range of entities that report externally. The debate is now about the extent of change to standards, and whether separate standards may be needed for different types of entity.

Work the Ministry of Economic Development and the Accounting Standards Review Board are doing

5.9
The discussion documents released for comment by the Ministry and the ASRB have formed the basis for changes to setting financial reporting standards, including changes to the standards for the public sector.

5.10
The Ministry's discussion document considered the circumstances under which the law should impose requirements on entities to prepare, publish, and obtain assurance on general purpose financial reports. The ASRB document outlined its tentative proposals on the accounting standards to be used by entities required to prepare general purpose financial reports under the Ministry's document, and the level of assurance that should be provided on those reports.

5.11
Our comments in this Part about the work the Ministry and the ASRB are doing are limited to the financial reporting aspects of the discussion documents. Since the end of January 2010, when the documents closed for comment, both the Ministry and the ASRB have been doing work that we expect will lead to change.

5.12
The Ministry has been drafting legislation7 that, if enacted, would consolidate the functions for setting financial reporting standards into one statutory board. The statutory board would be a reconstituted ASRB to be known as the External Reporting Board, or XRB for short. The XRB would be responsible for setting strategy as well as designing and approving financial reporting standards.

5.13
The Ministry is also drafting legislation that would establish which entities are required to publish general purpose financial reports. A principle-based approach would be applied in determining those entities, and that approach would result in changes to the current requirements. However, the changes would not affect entities in the public sector, which would continue to be required to publish general purpose financial reports.

5.14
The ASRB has considered the submissions it received on its discussion document. It has created a work programme that includes in-depth consideration of the main issues that will inform the decisions about the form of the new financial reporting framework. Some of these issues include:

  • whether there should be a single set or multiple sets of financial reporting standards;
  • the viability of both International Public Sector Accounting Standards (IPSAS) and enhanced NZ IFRS for application by entities in the New Zealand public sector;
  • tiers of reporting and the criteria for allocating entities to the various tiers; and
  • the extent to which New Zealand and Australian financial reporting standards should be converged.

5.15
The ASRB provides regular updates on its website about its deliberations on the above and other issues. As part of its deliberations, the ASRB has tentatively agreed that user needs should be the primary criterion for assessing alternative frameworks. It has also tentatively decided that only financial reporting standards for profit-oriented entities should be converged with Australia at this stage.

5.16
The ASRB has recently concluded that, to meet users' needs, the new accounting standards framework should consist of two sets of accounting standards, one to be applied by profit-oriented entities and the other to be applied by public benefit entities.8 The ASRB is yet to outline and consult on the details of the proposed accounting standards frameworks. However, it has previously noted that IPSAS is a viable alternative for financial reporting standards for the public sector. The ASRB has not yet deliberated on the tiers of reporting and the criteria for allocating entities to tiers.

5.17
We are pleased to see user needs as the primary criterion. We are also pleased with the conclusion that the accounting standards framework should consist of two sets of accounting standards, and that IPSAS is a viable set of standards for the public sector. We have been advocating using IPSAS as the basis for financial reporting standards in the public sector for more than 18 months.

5.18
The ASRB is expected to continue its deliberations and form views on outstanding issues. It is also expected to consult further on changes that it proposes the XRB would formally adopt after it is established.

Current financial reporting issues in local government

5.19
A number of current financial reporting issues affect some local authorities or their subsidiaries. We comment on six of these issues in this section. The issues are:

  • the complexity of financial reports;
  • service performance reporting;
  • underlying profit disclosures;
  • accounting for income taxes;
  • hedge accounting; and
  • proposed changes to financial reporting standards.

Complexity of financial reports

5.20
Because of the amount of information that NZ IFRS requires to be disclosed, financial reports have become generally more complex and much larger. Complexity and excessive disclosures are a problem because members of governing bodies and other people who use financial reports often find it difficult to understand the information. Complexity has also meant some entities require external help to prepare their financial reports, which comes at a cost.

5.21
In the public sector, the main reasons entities are required to prepare financial reports are to account for their use of public funds and, to a lesser extent, to help readers of the reports to make decisions. Therefore, in our view, clear, straightforward information is going to best discharge this accountability obligation.

5.22
We would like to see financial reports simplified as much as possible, particularly fewer disclosures in the notes to the financial statements. However, given the current approach to setting financial reporting standards and the time it would take for any changes to be effective, the issues of complexity and excessive disclosures are likely to continue for some time yet.

Service performance reporting

5.23
Many entities are required to report on their service performance. It is generally recognised that this reporting could be improved. Improved reporting on service performance fits well with the Government's desire for better effectiveness, efficiency, and value for money from the public sector.

5.24
Service performance reports are a crucial part of the accountability documents in the public sector. It is important that the service performance reports work with the financial statements to convey a coherent and consistent picture of each entity's performance. This is because true accountability requires transparency about financial and service performance, and an appropriate relationship between the two.

5.25
We have been seeking improvements to service performance reporting for a number of years, and we are pleased to see improvements occurring. We discuss our work on service performance reporting by local authorities in Article 4 in Section 2.

Underlying profit disclosures

5.26
A number of the more commercial entities, such as council-controlled trading organisations, have been including and commenting on underlying profit amounts in their annual reports. Some councils have also reported an "underlying profit". The underlying profit amount is different to the profit in the financial statements, which is based on accounting requirements in NZ IFRS.9 The term "underlying profit" is not defined in financial reporting standards, but it typically excludes the effects of accounting for changes in the value of financial instruments and "one-off" transactions.

5.27
We understand that the more commercial entities are reporting such amounts in response to the complexity of financial reports, combined with concern that their financial reports based on NZ IFRS are not fairly reflecting their performance. These entities see the requirements to recognise fair value movements as complicating their financial reports, which is why they make adjustments to exclude the effects of those movements. Also, the economic downturn has resulted in impairments, restructurings, and other so-called one-off costs. By removing these movements and costs, entities consider they are better reporting underlying financial performance.

5.28
Although we encourage entities to include information in their annual reports that is likely to be relevant to users, we have some unease about the practice of disclosing underlying profit. Reasons for our unease include:

  • There is no guidance on what underlying profit is, or how it is arrived at, and therefore inconsistent practices could occur among different entities.
  • Underlying profit often receives significant prominence in the annual report, and could overshadow financial information based on NZ IFRS.
  • Underlying profit is not always clearly labelled as supplementary information additional to that required by NZ IFRS.

5.29
We are aware that, internationally, standard-setters are reconsidering how best to present income in financial statements. It is not clear whether that work will result in information that better presents the financial performance of entities, so that the need for underlying profit disclosures is eliminated or at least reduced.

Accounting for income taxes

5.30
The removal of tax deductions for depreciation on buildings has had a significant effect on the financial statements of entities that both own buildings and pay tax, such as a number of council-controlled organisations. The effect is a significant increase in both the tax expense and deferred tax liability recognised in financial statements of such entities.

5.31
Many people, including preparers of financial statements, have been very critical of the financial reporting standard that requires the recognition of larger deferred tax liabilities. They consider that the increase in the deferred tax liability does not represent the underlying economic reality of the removal of tax deductions for depreciation on buildings.

5.32
Unfortunately, in contrast to many other financial reporting standards dealing with other assets and liabilities, the standard on income tax does not allow for the discounting of deferred taxation balances. The lack of ability to discount appears to be at the heart of the issue.

5.33
Although the removal of tax deductions for depreciation on buildings brought the issue to light again in the financial year to 30 June 2010, the issue with the standard has existed since it was adopted at the end of 2004. Given the current approach to setting financial reporting standards, the issue will continue to exist until changes are made to the international financial reporting standard on tax.

Hedge accounting

5.34
The requirements in financial reporting standards that need to be followed for entities to hedge account for derivative transactions10 are stringent, particularly for entities that use derivatives infrequently. Those entities are unlikely to have systems or processes to meet the requirements of the standard, and therefore may choose not to hedge account or may overlook the requirements that would allow the entities to hedge account. In either case, hedge accounting is not applied even though it may best reflect the underlying economic reality of the transactions.

5.35
We acknowledge that it is important to be careful about applying hedge accounting, particularly given the ease with which derivative transactions can be entered into and the possibility of speculative derivative transactions. However, the stringent requirements mean that entities have no room for judgement about hedge accounting retrospectively, even though that may be appropriate for particular derivative transactions.

5.36
In December 2010, proposals to change the financial reporting standard about hedge accounting were issued for comment. The proposals more closely align hedge accounting with entities' risk management activities. However, the proposals retain many of the stringent process requirements, which remove room for judgement about applying hedge accounting.

5.37
We would prefer hedge accounting requirements to allow more room for judgement, particularly for smaller entities or those that use derivatives infrequently, because in our view that would better serve the entities and the users of the financial statements of those entities. Given the current approach to setting financial reporting standards, this issue will continue to exist until further changes are made to the international financial reporting standard on financial instruments.

Proposed changes to financial reporting standards

5.38
In July 2010, a proposal was published to change a number of standards within NZ IFRS in the interests of aligning New Zealand and Australian financial reporting standards for profit-oriented entities. The proposed changes affected all aspects of financial reporting, including recognition, measurement, presentation, and disclosure. The proposed changes would mainly result in the undoing of previous changes New Zealand made to IFRS when establishing NZ IFRS. In other words, the proposed changes would more closely align NZ IFRS to IFRS. Other changes would result in some requirements being moved to a new standard.

5.39
We reviewed the proposed changes. We were concerned that, although the motivation was to align New Zealand and Australian financial reporting standards for profit-oriented entities, most of the proposals inadvertently affected all other entities. We provided detailed comments on the proposals, which can be summarised as follows:

  • Proposals affecting recognition, measurement, and presentation are not in the best interests of high-quality financial information for those who use financial statements.
  • Proposals to relocate unrelated specific New Zealand requirements to one New Zealand standard are not helpful to preparers of financial statements.
  • Proposals to remove minor disclosure requirements and low-level guidance do not appear to affect those who use financial statements in a significant way.

5.40
The proposals have not yet been finalised and, therefore, do not currently affect the financial statements of entities in the public sector. We hope that the proposals will be reconsidered rather than finalised as proposed, because of our concern that many of them are not in the best interests of either those who use financial statements or those who prepare them.

6: The Ministry's discussion document was entitled The Statutory Framework for Financial Reporting. It can be downloaded from the Ministry's website – www.med.govt.nz. The ASRB discussion document, which was a companion to the Ministry's document, was entitled Proposed Application of Accounting and Assurance Standards under the Proposed New Statutory Framework for Financial Reporting. It can be downloaded from the ASRB website – www.asrb.co.nz.

7: The draft legislation is the Auditor Regulation and External Reporting Bill, which at the time of writing was before the Commerce Committee.

8: Public benefit entities are defined as reporting entities whose primary objective is to provide goods or services for community or social benefit, and where any equity has been provided with a view to supporting that primary objective rather than for a financial return to equity holders. Public benefit entities in the public sector include such entities as local authorities, licensing trusts, cemeteries, administering bodies, government departments, district health boards, tertiary education institutions, schools, fish and game councils, other Crown entities, and Māori trust boards.

9: Terminology other than "underlying profit" may be used to describe a profit amount that differs to the profit based on NZ IFRS. Examples of such terminology include "underlying result", "underlying earnings", "normalised result", "result before non-recurring items", and "result before significant items".

10: Derivative transactions are transactions to be settled in the future that require no or only a small initial investment, and where the value changes in response to changes to an external variable such as an interest rate, commodity price, foreign exchange rate, or consumer price index. Common derivative transactions include foreign exchange contracts and interest rate swaps. Such transactions can provide an entity with some level of certainty for the underlying transaction, commitment, asset, or liability. Hedge accounting recognises the offsetting effects on surplus or deficit of changes in the fair value of the derivative and the underlying transaction, commitment, asset, or liability.

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